Fed's Evans Says US Is In A Liquidity Trap, Says Boosting Inflation Is "Entirely Appropriate"

As if we needed any further confirmation that the Fed is now willing to risk an all out bout of hyperinflation, here it comes courtesy of Chicago Fed's Charles Evans, whose comments that inflation is "acceptable", and welcome, and is the only way to battle the "liquidity trap" the US finds itself in, mirror those of NY Fed's Dudley who earlier confirmed Zero Hedge expectations that $100 billion is too low a QE2 number. Which means that very soon the Fed will buy up every single Treasury in existence. It will also kill the dollar absent Europe continuing on its path from earlier today, and saying the stress test was, in fact, a lie.

Introductory Remarks

I would like to thank Eric Rosengren, Jeff Fuhrer and the
organizers for giving me the opportunity to speak on this panel today. I
would like to use this opportunity to expand the discussion about
additional communications tools available to central banks in a
low-inflation environment. In a nutshell, I think there are special
circumstances when price-level targeting would be a helpful complement
to our current and prospective strategies in the U.S. Clearly
communicating an expected path for prices would help guide the public’s
understanding of the Fed’s intentions while we carry a large balance
sheet and promise continued low interest rates for an extended period.

There are quite a number of academic studies of liquidity trap crises
that find either price-level targeting or temporary above-average
inflation to be nearly optimal policies;[1]
and yet, central bankers and the public generally loathe the idea that
even a temporarily higher inflation rate could be beneficial or be
consistent with price stability over the longer term.

Nevertheless, with potentially beneficial policies so well grounded
in rigorous economic analysis, I cannot stare at our current projections
for high unemployment and low inflation and think that these
projections are consistent with the best monetary policies to address
the Fed’s dual mandate responsibilities. Today, I want to expand the
discussion of these tools. After all, debate on the merits is healthy.

Of course, these are my views only and not those of my colleagues on
the Federal Open Market Committee (FOMC) or in the Federal Reserve
System.

Rationale: Much More Accommodation Is Appropriate

Let me be very clear about the setting for this proposal. In my
opinion, much more policy accommodation is appropriate today. In a
speech two weeks ago,[2]
I stated that I believe the U.S. economy is best described as being in a
bona fide liquidity trap. This belief is not a new development for me;
instead, it is a dawning realization. Risk-free short-term interest
rates are essentially zero. Both households and businesses have an
excess of savings relative to the new investment demands for these
funds. With nominal interest rates at zero, market clearing at lower
real interest rates is stymied.

In this setting, even a moderate expansion without a double dip will not lead to appropriate labor market improvement.[3]
Accordingly, highly plausible projections are 1 percent for core
Personal Consumption Expenditure Price Index (PCE) inflation at the end
of 2012 and 8 percent for the unemployment rate. For me, the Fed’s dual
mandate misses are too large to shrug off, and there is currently no
policy conflict between improving employment and inflation outcomes. The
economic theories that central bankers rely on for evaluating
appropriate monetary policy suggest to me that we need lower short-term
real interest rates than the current real federal funds rate of –1
percent. Indeed, if the federal funds rate were positive, I would
advocate substantial nominal reductions. But we are effectively at zero.

A variety of typical linear Taylor rules suggests around –4 percent.
In addition, some calculations for optimal monetary policy simulations I
have seen indicate that real rates of –3 or –4 percent between now and
the end of 2012 would boost aggregate demand enough to deliver
substantially lower unemployment by the end of 2012. If you reach the
conclusion that we are in a liquidity trap, or even near a perilous
liquidity trap, more accommodation is not data-dependent or a close
call.

How Does Price-level Targeting Help with Policy Communications?

If the Federal Reserve decided to increase the degree of policy
accommodation today, two avenues could be: 1) additional large-scale
asset purchases, and 2) a communication that policy rates will remain at
zero for longer than “an extended period.”

A third and complementary policy tool would be to announce that, given
the current liquidity trap conditions, monetary policy would seek to
target a path for the price level. Simply stated, a price-level target
is a path for the price level that the central bank should strive to hit
within a reasonable period of time. For example, if the slope of the
price path, which I will refer to as P*, is 2 percent and inflation has
been underrunning the path for some time, monetary policy would strive
to catch up to the path: Inflation would be higher than 2 percent for a
time until the path was reattained. I refer to this as a
state-contingent policy because the price-level targeting regime is only
intended for the duration of the liquidity trap episode. I will be more
concrete in just a moment, but first, where does such a policy come
from?

A policy that targets a price-level objective emerges from analyzing
standard—modern macroeconomic theory. The desirable properties of the
price-level target (or temporarily above-average inflation) become most
apparent in analyses that consider liquidity traps.

Figure 1(pdf) displays
the simplest example of a price path P* and its essential attributes.
The reader must judge for herself whether this policy could be
communicated straightforwardly and transparently to the public; my
personal viewpoint is that it is horribly cynical to think that good
communication is beyond our ability, especially if that is the best
policy. Here are some key elements:

The first policy component consists of announcing a state-contingent
entry into the P* policy. I think most of us imagine liquidity traps
with double-digit unemployment rates to be relatively rare events, on
the order of twice a century or less. Under such circumstances where the
central bank is missing both components of its dual mandate by a large
margin, there is justification for targeting a higher price-level path
in an effective, disciplined, and limited fashion. A credible
announcement of the policy is clearly crucial for stimulating the
correct expectations by the public.

The second policy component is to select the parameters for the
price-level path: the initial date when the index-path begins and the
slope of the path. Given the recognition delay in understanding the
implications of the liquidity trap, it seems reasonable that the path
would begin at some date in the past. My preference would be to select
December 2007, in part because it is the National Bureau of Economic
Research (NBER) peak of the business cycle. With regard to the slope,
for the sake of concreteness, I will illustratively suggest 2 percent
for the average inflation rate; this rate corresponds to the mode of
FOMC participants’ forecast endpoints for PCE inflation.[4] With this definition of the P* path, it is easy to see an emerging “inflation deficit” to date.

The third policy component is to communicate regularly and often to
the public that the intention of the FOMC’s policy actions is to achieve
this path within a reasonable period of time. At a minimal level, this
could simply be a disciplined guarantee regarding how long policy rates
will be held at zero; it is an elaboration of what the current “extended
period” language means. Other accommodative policies could be used to
further build the public’s confidence that the Fed is pursuing this
price-level path. The task of communicating many operational details
would follow the announcement. Indeed, even before reaching the P* path,
closing the gap would set the stage eventually for adjustments in
operational policy, such as the altering size of the Fed’s balance
sheet, taking reserve-draining actions along the way, and increasing the
rate of interest on excess reserves (IOER), among others.

The fourth policy component is to clearly state the terms for the
final, state-contingent exit from the P* policy. Determining that the
price-level path has been achieved with confidence is a critical
determination. Presumably, spending a few months at the price-level path
would be more important than simply the first achievement of the path.
Once the price-level path is achieved with confidence, the
forward-looking monetary policy strategy would return to focusing on 2
percent inflation over the medium term. Future policy misses on either
side of 2 percent would be “bygones.” Policy would continue to strive
for price stability over the medium term, which would be 2 percent PCE
inflation. The past inflation misses would be used to simply inform
current analyses of inflation pressures and improve future projections
and policy responses.

What Might the Experience with P* Look Like? Some Favorable Cases

Let me spend some time discussing alternative outcomes from this
state-contingent price-level targeting regime. Remember, the regime is
one where policy actions like large scale assets purchases (LSAPs),
communications actions, etc., strive to increase monetary accommodation
to hit the P* path within a reasonable period of time. Figure 2(pdf) shows
the implied inflation rates for a 2 percent P* path where the current
price gap is closed by the end of 2012. Given current forecasts for
inflation, this would be a rapid turnaround in the inflation picture.
Many questions regarding operational responses during this adjustment
would need to be addressed:

The inflation rates are relatively modest: 2.2 percent core
inflation in 2011 and 2.9 percent in 2012. For a policymaker with a
symmetric loss function around 2 percent, 2.9 percent is about the same
loss as 1 percent. This is not a significant change from current
expectations of policy losses. Of course, ensuring commitment to the
policy exit is presumably crucial for achieving 2 percent in 2013.

If short-term interest rates remain near zero during this
adjustment, real interest rates would be between –2 and –3 percent.
Perhaps that would be enough to improve labor markets and aggregate
demand sufficiently, but I personally put more faith in analyses that
suggest the liquidity trap is larger than this.

Consequently, in this scenario at the end of 2012, if resource slack
remains substantial and inflationary pressures are returning toward 2
percent over the medium term on account of credible policy commitment,
then a standard Taylor-rule prescription may still call for a relatively
low federal funds rate. And the size and composition of the Fed’s
balance sheet might also be consistent with accommodation. How much? The
ultimate decisions for monetary policy would continue to focus on our
dual mandate responsibilities; but inflation would be nearer our goal of
price stability and aggregate demand would be stronger.

As I mentioned, a 2 percent P* policy that achieves the target
path by the end of 2012 might leave unemployment still relatively high
given the implied real rates. Figure 3(pdf) displays
a more aggressive P* policy that is assumed to close by the end of
2013. This path rises at a 3 percent rate from December 2007 until
December 2012, and then reverts to the 2 percent slope, taken as price
stability. This path incorporates what Svensson (2003) refers to as an
initial “price gap to undo:” It allows the eventual price adjustment to
incorporate a lower real rate if that is what the economic analysis
suggests is most useful to increase aggregate demand. Over the course of
this hypothetical adjustment, inflation is about 3, 4, and 3 percent
from 2011 through 2013. Thus, policy can generate –3 and –4 percent real
rates: This achieves a substantially higher opportunity cost of holding
on to cash-like assets rather than lending and investing excess
reserves in productive activities and workforces.

Again, credible commitment to the price path P* is, of course,
critical to achieving the inflation endpoint of 2 percent over the
medium term. In this regard, a reduction in the size of the Fed’s dual
mandate shortfalls would reinforce the public’s perception that the
Fed’s incentives are appropriately aligned with exiting the P* policy
with medium-term price-stability in sight.

What Might the Experience with P* Look Like? Some More Challenging Cases

There are many operational aspects of a P* policy that require
much more elaboration and study. Nevertheless, let me mention three
clear situations that require more complicated responses. It is a
hallmark of the uncertain times that we face that these are at polar
extremes.

Delayed inflation

The first challenge is to imagine that inflation continues to remain
very low even after an announcement that monetary policy is following a
price-level path. As inflation delay continues, the “inflation deficit”
account builds. That is, the price gap gets larger, and implied future
inflation to attain the P* path grows. This would clearly be
nerve-wracking for policymakers, and the credibility of our commitment
to ever growing inflation rates would be crucial for the success of the
policy. If our resolve is credible, well-functioning financial markets
should get the message. After all, investors and lenders sitting on
cash-like assets would be building up an exposure to adverse future real
interest rates. And I would expect the financial press to help
communicate these investment risks on a regular basis. (I know I’ve felt
that sting already.)

As cash moves out of investment portfolios into the general economy,
inflation will rise as required by the price-level targeting policy.

Smaller resource slack and greater inflation pressures

The second challenge is to imagine that the degree of resource slack
in the economy is much smaller than many presume. One example would be
if the structural rate of unemployment was upward of 8 percent. In this
case, more accommodation could lead to higher inflation and a rapid
closing of the price gap.

As it turns out, this is not a challenge for the P* policy: A quicker
closing of the price gap harkens the exit of the state-contingent
price-level policy. The fact that unemployment would remain high would
be a signal that increasing aggregate demand alone is not enough to
address this problem. But monetary policy would have succeeded in moving
closer to price stability with the attending benefits from achieving
that policy goal. Confidently switching to the post-P* policy would
enhance credibility for price stability over the medium term. And we
would have done all that we could to address the employment
situation—which would also enhance Fed credibility, in my judgment.

Accelerating inflation once the price gap has been closed

The third challenge would be if inflation was surprisingly high at
the point when the price gap was eliminated and policy reverted to
targeting 2 percent inflation over the medium term. I regard this case
as extremely unlikely. Recall that we are embarking on this price-level
targeting policy in an environment of huge resource gaps, with minimal
inflationary pressures. (I actually think that the greater difficulty
will be getting inflation going in the first place.) But in the unlikely
occurrence that inflation accelerates beyond the levels we anticipate,
we have the tools to deal with it. Specifically, relative to initial
baseline scenarios, the Fed could more aggressively increase the federal
funds rate and interest on excess reserves (IOER), as well as drain
liquidity from our balance sheet. Furthermore, any higher inflation
would almost surely be associated with stronger economic growth and job
creation, so these stronger “exit strategy” actions would be entirely
appropriate.

Concluding Remarks

My objective today has been a simple one: to discuss a policy
tool that has received almost zero discussion, though it regularly comes
out of careful analyses of mainstream economic models that we use to
assess monetary policy options. We should put this policy tool on the
table and debate its suitability to the current situation in the U.S.

Most critiques I have heard of this type of policy tool involve the
risk of runaway inflation expectations or the loss of hard-earned
credibility. My response is to continually fall back on the discipline
of the state-contingent exit plan. A central bank exercising this policy
would have to credibly convey to the public that this policy will end
when the price gap is closed. An important risk would be the temptation
to keep policy easy if the labor market has not reached the vicinity of
full employment. Depending on the parameters of the P* path, inflation
expectations and the size of resource slack, the price gap could close
before unemployment is reduced toward 6 percent or lower. Nevertheless,
credibility requires exiting the P* policy at this point. Doing so
ensures that this is a conservative policy, with prudent risk-mitigants
against outcomes that monetary policy is unable to improve upon.

But I am more hopeful for this policy’s potential to improve upon our
current liquidity trap economic conditions. I hope that my comments
have helped expand the debate over the past few weeks.

Notes

[2] Evans (2010). See also my interview with The Wall Street Journal in Hilsenrath (2010).

[3]
In the speech cited earlier, I also discussed the relevant evidence on
job mismatch and the Beveridge curve. I find unconvincing the argument
that the natural rate of unemployment has risen enough to deter
additional substantial policy accommodation.

For the remainder of my comments, I will take 2 percent to be the FOMC’s
explicit inflation objective over the medium term. This is not a
decision that has been taken by the FOMC. I simply use 2 percent to
facilitate the development of my comments.